Banks open their doors on to the world of Islamic finance

This is a measure of the momentum that Islamic international finance has gathered in the past two years.

Capital markets issuers and investors are increasing in number, even as the range and sophistication of Islamic products in other areas, like trade finance and treasury, continues to grow. What started as a sharply-defined niche is showing signs of becoming a permanent and sizeable industry, as opposed to a passing fancy.

One such sign is that, as structures evolve, there is a growing agitation for harmonisation of standards. Another is the increasing interest of non-Islamic lenders, borrowers and arrangers. The German state of Sachsen-Anhalt caused some eyebrows to be raised when it unveiled a €100m sukuk last year. However, whether the deal was a bond market blip or the start of a trend remains to be seen.

Issuance grows rapidly

Sukuk issuance, both corporate and sovereign, totalled about $6.7bn in 2004, according to figures gathered by the Islamic Finance Information Service. That compares with $1.9bn in 2003. What is driving this growth?

At root, Islamic finance is a highly specific manifestation of the ethical investment phenomenon and it is catching on fast. “More and more educated Muslims are being attracted by this corporate and social responsibility movement,” says Iqbal Kahn, CEO of HSBC Amanah Finance, HSBC’s Dubai-based Islamic finance subsidiary and one of the dominant international players in the new market.

The growing popularity of Islamic finance has caught the eye of Western and Far Eastern organisations, which recognise it as a useful alternative funding source as well as a helpful marketing device. In the realm of trade finance, Western companies have been turning to Shariah-compliant finance as a way of oiling the wheels when doing business with Islamic countries.

“Many conventional issuers have tapped the Islamic market to attract affinity investors,” Mr Kahn confirms. “If there is a preference for that mode of finance then they will make it available.”

Cross-border effects

Non-Islamic companies’ bankers usually have only limited credit lines available for Islamic countries, Mr Kahn says. “So Islamic finance allows access to another important source of cross-border lines.”

Others agree. “It has a lot of public relations value if you are dealing with Islamic countries or countries trying to promote Islamic finance,” says Arul Kandasamy, director of Calyon Corporate & Investment Bank’s Bahrain-based Islamic banking unit. “It gets you name recognition with local banks and in local markets.

“Some European companies that previously funded their subsidiaries from head office are now looking to fund them locally. One option in the Middle East is to use Islamic finance.”

Changing demands

The dynamics of demand are shifting, according to Usman Ahmed, vice-president responsible for Islamic capital market and loan transactions at Citigroup London. Citigroup was at the top of the Islamic bond tables in 2004, lead managing more sukuks by value than any other bank. “Previously, the market was entirely investor driven,” Mr Ahmed says. “But in the last couple of years, we have seen that the number of issuers is not necessarily restricted.”

He cites the case of Saudi mobile phone operator Ettihad Etisalat, which recently raised $2.35bn in loan finance, having insisted that only Islamic structures would be considered. The response from conventional banks was as energetic as that from Islamic institutions. “Growth will increasingly be driven by issuers,” he predicts. “And they will be offering more share to Islamic investors. Islamic investors are becoming more sophisticated, responsive and aware of opportunities – on a par with conventional [investors].”

Governing principles

The spread of Islamic trade finance structures has helped to prepare the way for the recent upsurge in international bond market activity. One of the main reasons that the capital markets are only now following in the footsteps of trade finance harks back to the nature of Islamic finance.

Islamic law – Shariah – forbids the giving and receiving of interest. One of the most widely used Islamic trade finance structures is murabahah. This is a form of cost-plus financing in which the lender buys the asset and sells it to the borrower at a profit (usually calculated with reference to an interest rate benchmark) for a series of deferred payments.

Its fixed-price nature makes murabahah suitable only for relatively short terms – typically two years, although the structure has been used for longer. Even worse, from a bond market perspective, a murabahah debt obligation is not tradable at anything other than par.

A way round this is ijara, in which the lender leases the asset. Since an ijara represents an interest in the underlying asset rather than the debt obligation, it may be freely traded. ‘Interest’ is paid in the form of rental, with regular assessments to check if the level of rental remains fair.

“Ijara gives you the ability to extend tenors to 10 or more years,” says Neil D Miller, head of Islamic finance at solicitors Norton Rose. “Every Islamic capital markets transaction completed to date involved a lease-type structure.”

Instead of receiving a coupon, sukuk investors participate in the income stream from underlying, securitised assets. In a Western environment, however, the buying and selling of assets attracts duties and taxes that can make the transaction less attractive.

In last year’s Sachsen-Anhalt sukuk and in the earlier $250m Bahrain Monetary Agency issue, arrangers Citigroup replaced the typical sale-and-leaseback structure with a head lease and sub-lease. This avoided transfer taxes while giving fully enforceable rights over the leased assets to the special purpose vehicle that issued the sukuk.

Although the assets underlying existing sukuks are invariably real estate, this could evolve. “There is no reason why the underlying assets should not be ships or aircraft, or perhaps a pool of assets, like cars,” Mr Miller says.

Structure and standards

The next challenge will be to devise a sukuk that is tradable without the issuer having to provide assets for the structure – and that is not smothered by the weight of its own paperwork.

The acceptability of Islamic structures is determined by boards of Shariah scholars; they are consultants and de facto regulators at the same time. Most banks and investors have their own panels, the member of which do not need to agree. And Shariah interpretations in core Middle East countries like Saudi Arabia and Kuwait tend to be stricter than in, say, Malaysia or Indonesia.

Some in the industry now believe that it is time to apply some universal standards, not least to cut the time it takes to bring transactions forward. “We must make sure that the regulatory framework continues to evolve at the same pace as the market,” says HSBC’s Mr Kahn. “There is a need for harmonisation of the best standards.”

He acknowledges the work of pan-industry bodies like the Accounting and Auditing Organisation for Islamic Financial Institutions and the Islamic Financial Services Board. “We need more of that standardisation. That will lead to more size and volume in Islamic transactions,” he says.

Will increased size and volume be accompanied by more capital markets participation from beyond the Islamic world? One obstacle is the absence of a secondary market for sukuks, although some believe that this will develop in time.

“A secondary market is still significantly lacking,” Citigroup’s Mr Ahmed acknowledges, attributing this mainly to a shortage of issues in the market. “But it’s more a function of not wanting to sell than not wanting to buy, and this will definitely change. The more issues we have, the more opportunities investors will have to choose from.”

For non-Islamic investors, an Islamic issue only has to meet their credit criteria to be acceptable. Two-thirds of Sachsen-Anhalt’s AA-/AAA Euribor flat five-year sukuk was distributed in Europe and only one-third in the Middle East. That deal distribution highlights the problem for any aspiring non-Islamic issuers, including creditworthy supranationals like the European Investment Bank, which is said to be contemplating a sukuk: Islamic investors tend to focus more on yield than on credit rating.

“The Middle Eastern investor base does not distinguish all that much between credits,” says Gilles Franck, head of debt capital markets (Eastern Europe, Middle East and Africa) at BNP Paribas. “Given a choice between an AAA and an AA credit, with a yield pick-up on the latter, the average Islamic investor will choose the AA,” he says.

Gilles Franck: ‘Until there is more credit differentiation, Sachsen-type issues will be quite rare’

“Funding at Libor minus is not acceptable to most Islamic investors. It’s a learning process but, until there is more credit differentiation, Sachsen-type issues will be quite rare,” says Mr Franck.

Mr Kahn argues that Islamic investors will accept very aggressive pricing, as long as the risk is familiar to them, as in the case of Islamic Development Bank and Dubai’s Department of Civil Aviation. The same goes for what he calls the “myth” that Islamic investors do not buy long-term deals: they will do so in a market they know, he says. “It’s another myth that they will only deal with Muslim issuers. They will deal with any issuer, as long as the sector is acceptable – not brewing or defence, for example – and as long as the documentation and structure is compliant,” says Mr Kahn.